13.5 Unintended Consequences of Macroeconomic Stabilization Policies

The first example of the deliberate use of tax policy to fine-tune the economy and promote economic expansion was the Revenue Act of 1964, proposed by President Kennedy in 1962 in response to a recession that had begun in 1960, the year he was elected president. The delay between the proposal of the act and its passage is an example of the implementation lag we discussed earlier. The policy was designed by Kennedy’s Council of Economic Advisors, two of whom (Robert Solow and James Tobin) later won the Nobel Prize in Economics. The act reduced federal personal income tax rates by about 20 percent and further reduced the corporate income tax rate by 4 percent after an initial reduction in 1962. The tax reductions had a large positive impact on employment and economic growth, with the unemployment rate falling from 6.6 percent in 1961 to 3.8 percent in 1966, and the rate of economic growth increasing from 2.3 percent in 1961 to 6.6 percent in 1966. Between 1961 and 1966, real GDP increased by 31 percent.

This early success in using expansionary fiscal policy to promote economic recovery and faster growth was not always replicated with other changes in tax policy. For example, the federal income tax rebate programs of 2001 and 2008, designed to promote recovery from recessions, had impacts on economic activity that were relatively smaller than the tax cuts of 1962–64. The explanation for the different impact magnitudes of the tax cuts of the 1960s and those of the 2000s lies in the duration of the tax changes. Economists have found that when tax reductions are temporary, as was the case with the tax rebates, individuals on average save most of the increase in their disposable income or use it to repay debt. Because they do not perceive a permanent change in their disposable income, they do not change their spending habits very much. However, if the government reduces personal income tax rates, individuals perceive that their disposable income is now permanently higher, so they will spend most of the increase on consumer goods and services. The tax multiplier is higher for permanent changes in taxes and lower for temporary changes in taxes.

Earlier in this topic, we discussed the use of monetary and fiscal policy to promote economic recovery from the sharp recession of 2020. Fiscal policy was very expansionary, with a total of $5.6 trillion in government spending and tax cuts in 2020 and 2021. This was equal to about 28 percent of 2019 (pre-pandemic) GDP. No doubt the quick response of expansionary fiscal policy helped keep the recession short and prevented GDP from falling even more than the actual 9.1 percent decline. Monetary policy was accommodating, and the maintenance of very low interest rates prevented crowding out of fiscal policy. In response to expansionary macroeconomic stabilization policy, GDP increased by 7.6 percent in the third quarter of 2020, and the economic recovery continued into 2021. The American Rescue Plan of March 2021 was controversial, with some economists believing that the additional $1.9 trillion stimulus would overheat the economy and lead to long-term inflation. Economists in the Biden administration and the Fed believed that any inflation resulting from the ARP would be moderate and short term. In reality, the inflation that resulted from the expansionary fiscal policy was high and long term.

The analysis of the contribution of expansionary monetary and fiscal policy to the period of inflation that followed the recession of 2020 is ongoing. One thing is clear. The stimulus money increased the demand for goods and services faster than supply could respond. Hence, the rate of inflation increased from 2.1 percent in 2020 to a 9.1 percent annual rate in June 2022. Why were government economists wrong about the inflationary effects of the $1.9 trillion stimulus of 2021? Because the stimulus money was temporary, the policymakers knew that the fiscal multiplier would be relatively small. Perhaps the dire economic circumstances of many households during the pandemic forced them to spend a larger portion than expected of their increased income. If so, the fiscal multiplier was larger than expected. Perhaps the economists overestimated the ability of a recovering economy to expand output to meet increased demand. If so, excess demand for goods and services would continue to put upward pressure on the price level. Another possibility is that worldwide supply-chain problems that prevented U.S. firms from accessing inputs necessary to expand production were more persistent than economists expected.

These examples serve to illustrate the difficulty of formulating and implementing countercyclical macroeconomic stabilization policies that will have exactly the effect on unemployment rates, inflation rates, and economic growth that policymakers intend. Nevertheless, when there are surprises in the impact of these policies, careful economic analysis leads to insights that can help improve future policies.